Futures or Options - Which Should I Use to Protect Price

Heather Moffatt, Grain Risk Management Advisor, Agricultural Marketing First

The market environment of the last month has left us with some excellent price opportunities. The strength in corn has come with anticipated demand gobbling up current supplies. Soybean prices have kept up so acres don’t decline. World wheat stocks have never been tighter. Futures have rallied, with values at historically high levels. Current strong commodity prices are beneficial to producers advocating the Risk Management Program. At these levels the program demonstrates to government the Risk Management Plan is cost effective and feasible. At prices today you can illustrate payouts wouldn’t be triggered every year based on price averaging.

There are different ways to protect prices and stay in the market before and after cash values are decided. Let’s take a look at two alternatives and their impact on your marketing program. As most of you are aware, when you sell grain to your local elevator they have to protect their position. If merchandisers do not have a market for your corn immediately they run the risk of the price falling before making the sale. A futures transaction then occurs to protect a cash transaction. To protect price, a “short” futures contract is initiated (sell a futures contract). If the price falls, the merchandiser can collect the amount below their hedge point. For example, the day they bought corn from you, March futures were 3.61, so they would initiate a short position. On February 2nd they sold corn to a feed mill. That day March futures traded at
3.40. They offset, or bought back the short position, and put 21 cents in their trading account. At the same time they sold the corn to the feed mill at 3.40, and made up the 21-cent loss with their short hedge. On the other hand, if corn futures had gone higher - 3.85, they would owe 24 cents, but at the same time would make 24 cents on the sale to the feed mill. Both scenarios work back to the original purchase price of 3.61
March. The “short hedge” shifts the opportunities and risks associated with merchandising away from price movement and on to basis movement. To merchandisers, grain has no price. It is only the basis at which grain can be bought or sold that is relevant.

As producers, your objective is to lock in the best realistically obtainable price for what you produce. Unlike the merchandiser who trades millions of bushels and profits from basis and spreads, the farmer depends on the sale of his bushels as yearly revenue. Using realistic price objectives and a diversified pricing program, you attempt to arrive at a good price year in and year out. To protect price on unsold bushels,
you can either short (sell) futures or buy put options. At the time of writing, March futures are trading at 3.64. A 3.60 March put with an
expiry date of February 23, costs approximately $.19. If futures values fall, your downside price protection starts at 3.60. Take off the cost of
the put and your floor actually starts at 3.41. If you have not sold your corn by the time February 23 comes, you must re-establish your floor again in May or July. The position you take in the next months is designated by the price at that time. If March corn were lower than your 3.60 put, you would sell it, take the profit and buy a put in May. If March corn were to trade higher than the 3.60 put, there would be no
value in the option and you may choose to re-establish a put in May to continue coverage.

The other alternative to protecting price is to short (sell) a futures contract. You would be doing the same as an elevator – protecting a specific price. If you shorted a March corn futures contract for 3.64 and the market dropped, you would be protected from that price down. If the market went higher, you would owe money on that position, but the sale of the cash would be your hedge. In the example below, the put position, downside protection doesn’t start until 3.60, and you must subtract the cost of the option premium. You have established downside
protection and your cost is known. This would be best if the market rallied after you established the position because the upside is fully available to you. In a flat or falling market the short futures hedge would be most advantageous.

Often it is difficult to decide which hedge to use. To protect prices trading a year or two in the future, options can be very expensive, have little liquidity and may not be trading at all. If you see a price you want to protect it may have to be with a short futures hedge. Disciplined hedgers will short deferred prices if they are historically high, and manage that price until harvest comes. It is important that your lender understand that hedging locks in historically excellent prices for your crop. They must also understand that your line of credit allows for margin money to manage that position should it move against you before delivery of your grain. Remember that your goal is to lock in good prices when they
present themselves. Your hardest job is to pick a price, lock it in, and be satisfied no matter what happens after the fact.